Stagflation and The Credit Cycle

Stagflation: When the general level of prices rises due to the purchasing
power of currency-money falling, instead of price inflation due to a general
increase in demand.

The credit cycle that normally drives advanced economies through boom and
bust is turning out to be different this time round. The boom between the Lehman
bust and the one yet to come never got going, because of very high levels of
existing debt. This condition will almost certainly lead to stagflation.

Normally a prolonged period of low interest rates stimulates demand for bank
credit to finance consumer demand. This time the signs are that a prolonged
period of extremely low interest rates has failed to stimulate much more than
asset prices. There are now signs that the global economy is stalling and there
will be no boom, because consumers are already maxed out.

Therefore, it is hard to see how US interest rate policy can ever leave the
zero bound. Unless something can be done to get the credit cycle back on track
again, today's high asset values may not be sustainable, and falling asset
values at times of exceptionally high debt can lead to widespread bankruptcies
and a self-feeding slump. If the income earned by productive assets is not
growing, something else will have to supplement it. At the very least this
will involve an indefinite extension of very low interest rates beyond 2015.
And every time asset values show signs of flagging, monetary intervention will
be required.

In the US, asset inflation has been the Fed's objective since the Lehman crisis
in 2008. However the exit plan was always to stimulate economic growth, allowing
fiscal imbalances to reduce and interest rates to return to more normal levels.
So signs that the US and global economies are now stalling raises the possibility
that zero interest rate policy is going to be with us for many years yet. As
long, that is, as price inflation remains subdued.

This is where monetary policy will come unstuck. The purchasing power of a
currency can vary independently from economic demand, giving rise to stagflation.
Technically this is inflation in a stagnant economy reflecting a change in
preference against money in favour of goods. If the currency in question is
the dollar, the reserve currency against which all others are benchmarked,
the purchasing power of the whole currency complex can fall without any improvement
in economic conditions.

Ultra-low interest rates, with no realistic possibility of rising to a proper
market rate, will eventually undermine any currency's purchasing power. The
authorities will be helpless, because to raise interest rates sufficiently
to restore monetary confidence will almost certainly bring about the bankruptcies
deferred since the Lehman crisis, potentially collapsing the west's entire
financial system. The Volker response in 1980 of sharply higher interest rates
to similar conditions then is not a policy option today.

In a nutshell, the conditions now exist for a decline in the purchasing power
of all major currencies. If this happens it will result in prices of everything
inexplicably rising; and if it becomes apparent to the general public that
interest rates cannot be permitted to rise, stagflation will rapidly become
impossible to control.

Alasdair Macleod runs FinanceAndEconomics.org,
a website dedicated to sound money and demystifying finance and economics.
Alasdair has a background as a stockbroker, banker and economist. He is a
Senior Fellow at the GoldMoney
Foundation.

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